Brian Fallow: Vexed question of bank bailouts

If management or shareholders thought rescue was on the cards there could be an incentive to take risks.

When people deposit money in a bank account they do not think they are engaging in a risky activity. Photo / File

It is a bit embarrassing for a business journalist to admit, but I was a shareholder in the Bank of New Zealand when in 1990 it failed and the government had to bail it out.

I was also, in an equally modest way, a depositor.

The sudden worthlessness of the BNZ shares was just one of those things. It is a risk you run with equity investment. Caveat emptor.

But I would have felt a whole lot less philosophical if the authorities had swiped some of the money in my bank account, in the cause of keeping the bank open for business.

I must also admit that even now, when I entrust a little more of my hard-earned money to the bank, I do not go up to a teller and say, "I'm thinking of becoming an unsecured creditor of your business. But first I would like to see your latest disclosure statement please, just in case there is more sectoral concentration in your loan book than I am comfortable with."

I would be surprised if anyone else did either.

There is an air of unreality about the Reserve Bank's discussion of its plans for Open Bank Resolution - or how the authorities might handle a bank failure - and the issue with which it is inevitably entangled, whether we should have deposit insurance.

The Reserve Bank's head of prudential supervision, Toby Fiennes, in a speech to the Institute of Directors last week, said that if the authorities fostered expectations that a failed bank would receive a government bailout, the incentive for its management, shareholders or depositors to minimise the risks of failure was much reduced.

Deputy Governor Grant Spencer in an op-ed late last year said OBR would strengthen the incentives for creditors - which in the bank's lexicon seems to include depositors - to closely scrutinise bank management, something that would be eroded if it was assumed the Government would bail out a failing bank.

In similar vein the Finance Minister, Bill English, explaining two years ago why the Government does not favour compulsory deposit insurance, said it blunted incentives for both financial institutions and depositors to monitor and manage risks properly, as well as being difficult to price.

The argument is that a safety net for depositors creates "moral hazard" by undermining their sense of the trade-off between risk and reward in interest rates, nudging the banks towards riskier lending.

But really it is the Reserve Bank's job, as the banks' supervisor, to provide the close scrutiny; it's depositors' job to earn the money entrusted to the bank.

You can argue that all commerce involves an element of trust and a risk that the trust will be misplaced.

But banks are different. They are vital infrastructure for the economy.

When people deposit money in a bank account they do not think they are engaging in a risky activity.

You can bank on that.

The OBR regime is intended to minimise the damage to the financial system and the economy if a bank fails.

It is designed for the the extreme case when the normal lines of defence - the professionalism of the bank's staff, the governance of its board and the vigilance of its prudential supervisors - have all fallen short.

It aims to ensure that when a bank is put into statutory management it reopens for business the next business day, so that the channels through which payments flow into and out of the bank are closed for the shortest possible time.

Overnight, or over the weekend, the authorities will have formed an estimate - easier said than done - of the gap between the insolvent bank's assets and liabilities.

Shareholders are the first to lose their money, followed by holders of the wrong sorts of bonds, but if there is still a shortfall, depositors receive a "haircut". A percentage of their funds will be frozen, while the Government guarantees the rest, which will be made available to them the following day.

Fiennes said OBR gave the Government options other than bailout and liquidation, both of which might be unpalatable, but did not change the basic framework of insolvency law.

"It does not change the fact that depositors' and other creditors funds are at risk.

It is a well-established legal principle that people stand to lose money if a business that owes them money cannot meet all its obligations. Banks are the same as any other business in this regard," he said.

"It does not change the ranking of creditors. Shareholders will be the first to lose their investment. Once shareholder funds are exhausted, subordinated creditors bear losses, followed by all other unsecured creditors on a pari passu basis, meaning that those with an equal legal claim get equal treatment." Most countries are not so pure.

They have deposit insurance schemes that guarantee deposits up to some level.

Dr David Tripe, director of Massey University's centre for banking studies, says that if OBR had a de minimis threshold of, say, $50,000 before haircuts applied, that would amount to a deposit insurance scheme, although in principle it is better if those who benefit from insurance have had to contribute towards the cost of it.

Indeed, there is provision for a de minimis threshold in the design of OBR, at the Minister of Finance's discretion.

Tripe also points out that the days when all bank creditors were unsecured are gone, citing in particular the legislation, currently well advanced through the parliamentary process, which gives the holders of covered bonds prior claim to a bank's mortgage book.

His more fundamental criticism of OBR, though, is that the prospect of a haircut on deposits could increase the risk of a run on the bank if there was any question about its soundness.

Fiennes in his speech acknowledged that some form of depositor protection arrangement might make it easier for the government of the day to impose a solution such as OBR that did not involve taxpayer support, by dealing with the "noise" from depositor voters.

Brian Fallow is the New Zealand Herald's economics editor. A Southlander happily transplanted to Wellington, he has been a journalist since 1984 and has covered the economy and related areas of public policy for the Herald since 1995. Why the economy? Because it is where we all live and because the forces at work in it can really mess up people's lives if we are not careful.